Hamish McRae: Blair and G8 leaders are aiming their guns at the wrong targets

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The world's central bankers are right and the politicians are wrong. The guns are facing in the wrong direction.

The focus at the forthcoming G8 meeting in Gleneagles is on climate change and Third World debt. That is largely thanks to the British chairmanship and the priorities set by the Prime Minister and the Chancellor. It is easy to see why. These are hugely important long-term issues and our Government understandably wants to use the leverage of a summit to try to move the world forward.

All that is laudable. But while these may be the most important long-term problems of the world economy, they are not the most immediate ones. The most immediate threat comes from global financial imbalances.

This is not a media-friendly subject. You would not get rock stars throwing their talent into publicising this threat. But we can already see that it is these imbalances that will bring the current expansionary phase of the world economy to an end. The issue is how to manage them so that expansion throttles back gently to a steady state, rather than ending in a big bang.

The disagreement about priorities has been brought out into the open by David Dodge, the governor of the Bank of Canada. He gave an interview in which he regretted the lack of attention to imbalances and made the further point that there was no forum to discuss such matters because China, India and Brazil were not members of the G8.

In one sense the imbalances are an old story: the US current account deficit has been widening for several years, while the corresponding surpluses of China, Japan and the rest of Asia have been duly climbing. What is new is the complication of rising energy prices, driven largely by US and Chinese demand.

Back in February, the Paris-based International Energy Agency (IEA) estimated that world demand for oil would rise this year by 1.8 per cent to 84.0 million barrels a day. Now it estimates it will rise by 2.2 per cent. The only region in the world that is coming in lower than estimated is Europe, where the economic slowdown has cut demand. In the US, demand is expected to be up by 1.1 per cent (instead of 0.9 per cent) while in China, the world's second largest oil importer, it will be up by 7.2 per cent (instead of 6.3 per cent).

The relationship between the volume of Chinese oil imports and the oil price is shown in the first graph and that between changes in oil imports and changes in industrial production in the second. As you can see, there is a pretty close relationship in both cases.

In the case of the first, as imports have risen, so too has the oil price. That does not mean there is absolute causal link, for China is using only (only!) about 15 per cent of world oil production. But it has become the swing consumer, rather in the way that Saudi Arabia has been the swing producer.

In the case of the second, the relationship must be causal: obviously as industrial production expands the demand for oil goes up. The lines are not a perfect fit but it is hard to escape the conclusion that unless Chinese industrial production tanks, the country's oil imports will continue to climb.

GFC Economics, which produced the charts, noted that if the Chinese economic recovery continues, it might lead to a further upward revision of IEA estimates and, of course, further rises in energy costs.

This rise in the price of energy links with the imbalances story in three ways. First, it gives China an incentive to accept a revaluation of the yuan against the dollar, currently demanded by America. Oil is priced in dollars and a revaluation would cut the country's energy costs. Second, while the US continues to buy huge amounts of goods from China ­ running up the deficit ­ it will put pressure on the oil price. US demand affects the oil price in two ways: directly as a consumer of oil and indirectly as a market for Chinese goods. And third, the higher the price of energy the more incentive the Chinese have to try to collar oil supplies.

Were it not for the rising price of oil, I suspect that China and the US would have been content to continue their symbiotic trading relationship. The US would go on taking Chinese goods and China would have gone on buying US securities. The imbalances would continue ­ for while the China/US imbalance is not the only one, it is arguably both the most sensitive and the most important.

But the US has become almost paranoid about energy supplies. Seeing China scoop up supplies by doing deals with countries with which the US has a poor relationship, such as Venezuela and Burma, has enraged American opinion. Seeing it try to buy a US independent oil company, Unocal, has further tweaked the country's sensitivities. And seeing the pump price of petrol rising to an all-time record has given a populist twist to American concerns.

The imbalances may remain in most people's view a theoretical matter rather than something Americans should do anything about. But the oil price is intensely practical and has direct political implications. Why is President Bush so unpopular? Is it the cost of the war in Iraq or the cost of filling up the tank? It is both, of course, but my guess is that the latter is more important.

On the other hand, if slower growth in the US is the only way of cutting the trade deficit and cutting the price of oil, who wants that?

If the G8 were to focus on this quite immediate threat to the world economy, what might it be talking about?

For a start, it would be thinking about energy conservation ­ a narrower matter than climate change but a related one. It would be thinking about ways of including China in the debate and seeing to what extent China could be helped to meet its energy needs.

It would also be thinking about all the imbalances, not just the US/China one. Japan and much of Southeast Asia suffer from an excess of savings, just as the US suffers from a lack of them. It would be thinking of the limits of a Chinese revaluation, which would not have much of an impact on the US deficit. It would be worrying about the slow growth of Europe and the drag this is placing on the world economy.

And it would be trying to put in place a general agreement on currencies, so that were the dollar to fall sharply ­ unlikely just now but possible at some later stage ­ the authorities would be ready to steady the markets.

You are not going to get a fix out of a G8 meeting. What you want to do is to get an understanding among world leaders of the risks the world economy is running. The aim should be to make sure that policies in the year ahead will at the very least do no harm. And further, the G8 leaders should be thinking about restructuring the whole event so that it should be less formal and ­ by bringing in China, India and Brazil ­ more inclusive.

None of this is to argue that the present agenda is unimportant. Quite the reverse. But managing the present expansion so that it does not end in tears is also hugely important and it seems very odd that it should not be at the core of the debate.